The Great Unwind and the Two Most Important Prices in the World

“The cost of a thing is the amount of what I will call life which is required to be exchanged for it, immediately or in the long run.” – Walden by Henry David Thoreau

“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.” – Vladimir Lenin

“There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation.” – Herbert Hoover

The Federal Reserve for the better part of a decade has been engaged in the business of suppressing interest rates through the use of easy monetary policies and quantitative easing. For US bond market participants all the Fed’s policies entailing interest rate suppression meant that there was a perpetual bid for US treasury bonds and it was always at the best possible price. The Fed has recently embarked on the journey toward unwinding the suppression of interest rates through the process of quantitative tightening. QT has US bond market participants worried that there will be a perpetual offer of US treasury bonds at the worst possible price.

The Organisation of Petroleum Exporting Countries (OPEC) and Russia have, since late 2016, taken steps to prop up the price of oil by aggressively cutting output. With a history of mistrust amongst OPEC and non-OPEC producers and a lackadaisical approach to production discipline, oil market participants did not immediately reward oil producers with higher oil prices in the way bond market participants rewarded the Fed with immediately higher bond prices / lower yields. It took demonstrable commitment to the production quotas by the oil producing nations for oil market participants to gain the confidence to bid up prices. And just as confidence started to peak, Russia and Saudi Arabia signalled that they are willing to roll back the production cuts.

Arguably the US dollar and oil are the two most important ‘commodities’ in the world. One lubricates the global financial system and the other fuels everything else. Barring a toppling of the US dollar hegemony or a scientific breakthrough increasing the conversion efficiency of other sources of energy, the importance of these commodities is unlikely to diminish. Hence, the US (long-term) interest rates and the oil price are the two most important prices in the world. The global economy cannot enjoy a synchronised upturn in an environment of sustainably higher US interest rates and a high price of oil.

In the 362 months between end of May 1988 and today there have only been 81 months during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages – that is less than a quarter of the time. (These periods are shaded in grey in the two charts below.)

US 10-Year Treasury YieldSource: Bloomberg

West Texas Intermediate Crude (US dollars per barrel)

Source: Bloomberg

Over the course of the last thirty years, the longest duration the two prices have concurrently been above their respective 48-month moving averages is the 25 month period between September 2005 and October 2007. Since May 1988, the two prices have only been above their respective 48-month moving averages for 5 or more consecutive months on only four other occasions: between (1) April and October 1996; (2) January and May 1995; (3) October 1999 and August 2000; and (4) July 2013 and August 2014.

Notably, annual global GDP growth has been negative on exactly five occasions since 1988 as well: 1997, 1998, 2001, 2009, and 2015. The squeeze due to sustainably high US interest rates and oil prices on the global economy is very real.

Global GDP Growth Year-over-Year (Current US dollars)

Source: Federal Reserve Bank of St. Louis

On 13 June, 2018 President Donald Trump tweeted:

“Oil prices are too high, OPEC is at it again. Not good!”

And today, nine days later, OPEC and non-OPEC nations (read: Saudi Arabia and Russia) obliged by announcing that OPEC members will raise output by at least 700,000 barrel per day, with non-OPEC nations expected to add a further 300,000 barrels per day in output.

Iran may accuse other oil exporting nations of being bullied by President Trump but we think it is their pragmatic acceptance that the global economy cannot withstand higher oil prices that has facilitated the deal amongst them. (Of course we do not deny that a part of the motivation behind increasing output is bound to be Saudi Arabia wanting to return the favour to Mr Trump for re-imposing sanctions on Iran.)

Last week the Fed raised the Fed funds target rate by 25 basis points to a range between 1.75 per cent and 2 per cent. At the same time it also increased the interest rate on excess reserves (IOER) – the interest the Fed pays on money placed by commercial banks with the central bank – by 20 basis points to 1.95 per cent. The Federal Open Market Committee (FOMC) also raised its median 2018 policy rate projection from 3 hikes to 4.

With the Fed forging ahead with interest rate increases it may seem that it is the Fed and not OPEC that may squeeze global liquidity and cause the next financial crisis. While that may ultimately prove to be the case, the change in the policy rate projection from 3 to 4 hikes is not as significant as the headlines may suggest – the increase is due to one policymaker moving their dot from 3 or below to 4 or above. Jay Powell, we think, will continue the policy of gradualism championed by his predecessors Ben Bernanke and Janet Yellen. After all, the Chairman of the Fed, we suspect, oh so desires not to be caught in the cross hairs of a Trump tweet.

Investment Perspective

Given our presently bullish stance on equity markets, the following is the chart we continue to follow most closely (one can replace the Russell 1000 Index with the S&P500 or the MSCI ACWI indices should one so wish):

Russell 1000 IndexSource: Federal Reserve Bank of St. Louis

If the shaded area on the far right continues to expand – i.e. the US 10-year treasury yield and oil price concurrently remain above their respective 48-month moving averages – we would begin to dial back our equity exposure and hedge any remaining equity exposure through other asset classes.

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.